The interest rate increases and volatile markets point to rising financial stability risks as Central Banks accelerate monetary policy tightening to circumvent inflationary pressures from becoming more aggressive.
This is according to an update by the International Monetary Fund (IMF) based on its latest Global Financial Stability Report.
Risk to financial system stability has been entrenched by multi-decade high inflation, enduring geopolitical risks, volatile markets, and deteriorating economic outlook in many parts of the world.
Given preexisting vulnerabilities, the consequence of a disorderly tightening of financial conditions may become amplified. According to the report, advanced and emerging market economies also face magnified risks and vulnerabilities across different sectors with certainly different degrees in different regions.
For an emerging market economy like Nigeria, financial stress can become elevated for the government given its mounting debts. Additionally, sourcing external borrowing to finance the 2023 budget which has a projected deficit of N10.78 trillion could be at a significantly high cost.
Considering that bond issuance in US dollars and other major currencies has decelerated significantly since 2015 in emerging and frontier markets, without improved access to foreign funding, emerging economies like Nigeria will have to seek alternative sources and/or debt reprofiling and restructurings. According to the report, rising rates, worsening fundamentals, and large outflows have pushed up borrowing costs notably in emerging markets. Unless market conditions improve, there is a risk of further sovereign defaults in frontier markets.
What IMF is recommending
The IMF has highlighted that emerging markets are facing several risks, including high external borrowing costs, stubbornly high inflation, and volatile commodity markets. They also face heightened uncertainty about the global economy, and policy tightening in advanced economies. Hence, the fund made the following recommendations:
“Central banks must act resolutely to bring inflation back to target and avoid a de-anchoring of inflation expectations, which would damage their credibility. Clear communication about policy decisions, commitment to price stability, and the need for further tightening will be crucial to preserve credibility and avoid market volatility.”
“Exchange rate flexibility helps countries adjust to the differential pace of monetary policy tightening across countries. In cases where exchange rate movements impede the central bank’s monetary transmission mechanism and/or generate broader financial stability risks, foreign exchange intervention can be deployed. Such interventions should be part of an integrated approach to addressing vulnerabilities as laid out in the IMF’s Integrated Policy Framework.”
“Emerging and frontier markets should reduce debt risk through early engagement with creditors, multilateral cooperation, and international support. For those in distress, bilateral and private sector creditors should coordinate on preemptive restructuring to avoid costly defaults and prolonged loss of market access. Where applicable, the Group of Twenty Common Framework should be used.”
“Policymakers face an unusually challenging financial stability environment. Though no globally systemic event has materialized so far, they should contain the further buildup of vulnerabilities by adjusting selected macroprudential tools to tackle any pockets of risk. In this highly uncertain environment, striking a balance between containing these potential threats and avoiding a disorderly tightening of financial conditions will be critical.”